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‘Bearish divergence’ is warning investors not to buy the dip in the stock market

2015-09-07

A chart signal that warns you not to buy can be just as useful as one that warns you it’s time to sell. The long-term “bearish divergence” in the S&P 500’s chart suggests it is still much too soon to try to pick a bottom.

The bearish divergence was flashing a yellow light for stocks as far back as two years ago, but it didn’t turn red until a couple of weeks ago, when the S&P 500 SPX, -1.53% broke below support at the January low.

Bearish divergences don’t necessarily suggest investors should sell, but they do warn that when a breakdown in price does occur, they should not fight it. The pattern now indicates the index could fall a lot further before the opposite “bullish divergence” appears.

The Relative Strength Index (RSI) technical indicator, which compares the magnitude of recent gains with the magnitude of recent losses, is used by chart watchers to gauge the momentum of a market trend.

One way chart watchers use the RSI is to watch for when the RSI trend moves in the opposite direction of the price trend it tracks. When a bullish trend in price is accompanied by a bearish trend in the RSI—a “bearish divergence”--it implies the uptrend has lost momentum, and could reverse course at any time.

The bearish divergences depicted in the above chart are what the Market Technicians Association describes as the most-bearish type--“Class A bearish divergence”--as prices climbed to record highs while RSI hit distinct lower highs and lower lows.

On the flip side, a bullish divergence can be a strong buy signal, as the two big bear-market bottoms of the last 15 years show. The bad news is, it could take months and a much deeper decline before a bullish divergence appears.

With long-term indicators showing a bearish bias, “the focus remains on downside risk until we see a developed divergence bottom,” according to research and analytics firm Divergence Analysis.

On Friday, the S&P 500 dropped 1.2% in morning trade, after August jobs growth was less than expected.

That said, one of the basic tenets of technical analysis is that previous support tends to morph into resistance when revisited. The stronger the support, the stronger the resulting resistance.

The first area of potential resistance at the January lows was tested during last week’s bounce and held firm. Above that, the March and July lows around the 2,040 to 2,045 level should prove difficult to surpass.

On the downside, the 1,815 level could be important for the long-term outlook. That’s where an uptrend line drawn off the March 2009 low currently extends.

Below that, the 1565-1575 area sticks out on the charts for two reasons:

The first key retracement level based on the Fibonacci, or “divine ratio,” is around 1575. That represents a 38.2% retracement of the rally off the March 9, 2009 closing low of 676.53 to the May 21 high of 2,130.82.

• The S&P 500’s Oct. 9, 2007 closing high was 1,565, just before the Great Recession hit. That should have morphed into strong support.